Stocks Need Earnings Growth, Low Rates Do Not Expand Earnings Multiples
The idea that low rates lead to higher PE ratios is false; it merely does not work that way.

Stocks Need Earnings Growth, Low Rates Do Not Expand Earnings Multiples

September 5, 2020


Macro – SPY

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It has been a while since we took a look at the fundamentals of the market and where things stand. With a three weekend, it seems that this would be the appropriate time to assess the market from a valuation perspective. Overall, nobody can argue this market is fairly valued today, because it isn’t, not based on 2020 earnings, and it is hard to say it is fairly valued on 2021 earnings as well.

Currently, the S&P 500 trades for around 30 times 2020 earings of $113.75 based on estimates from S&P Dow Jones; it is also trading around 20.9 times 2021 earnings estimates of $164.01. Both of these numbers are high. When trying to adjust for the low rate environment, it gets tricky.

Some investors have tried to adjust the market for the earnings yield of the S&P 500 and the 10-year treasury. The tricky part is the earnings yield for the S&P 500 is around 3.3% for 2020 and 4.1% for 2021. The earnings yield is merely the inverse of the PE ratio. So the lower yield, the higher the PE ratio, the higher the yield, the lower the PE ratio. So I find that this method is not appropriate.

I have looked at the spread between the S&P 500 earnings yield and 10-year treasury rate. If you base it on that, we are basically in a reasonably valued region. But what is considered fairly valued appears to be more about the period, then some consistent formula. The period before 2000 was a period of high-interest rates. Therefore that spread was typically negative, while the recent period has a positive spread due to the lower rate environment.

But what seems most interesting is that from 1999 through the year 2012, falling rates did little to lift PE multiples on the S&P 500. So while it is true, there are fewer alternatives today in terms of where to put your money, falling yields did nothing to boost the valuation of the S&P 500, from a PE perspective.

In fact, rates were rising throughout 2016, 2017, and 2018, at the same we are were getting multiple expansion.

Falling and even negative interest rates did little to boost the PE ratio in Germany over the years.

It would appear that overall the movement in the market is correlated to changes and shifts in earnings trends.

We can see that more closely in the chart below with 12-month forward earnings estimates overlaid with the index itself.

It seems to suggest that if earnings trends do drive the direction of the market, and that PE multiple appears to be a reflection of future growth expectations. It may indicate the market at this point has reached its peak PE for this cycle, and multiple contraction is likely to return. It would suggest that for markets to go higher from here, we are going to need to see earnings growth return in a meaningful way in futures years.

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